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"Dollarization" of the Ghana Cedi- Simplified

"Dollarization" of the Ghana Cedi- Simplified

Source: Stephen Abrokwah, Ph.D.

Date: 21-03-2014 Time: 07:03:48:pm

Stephen Abrokwah, Ph.D. Ama Agyeiwaa Ferkah, Ph.D. Candidate

Recently, dollarization has surged to the forefront of Ghana's financial/economic scene. To understand dollarization, one needs to define what it means. Even though, the concept of dollarization has a wide variety of meanings and uses, the widely used definition of dollarization is the simultaneous use of a foreign currency alongside the home currency as a store of value, a unit of account, and a medium of exchange or the complete substitution of the domestic currency for a foreign currency. The later will be a case of full dollarization, (which is seen in countries such as Panama and Ecuador).

One important point to clarify is that dollarization does not require the use of the U.S dollar as the money being used in the economy as the proxy to the local currency. It could be any well stabilized currency, like the British Pound or the Euro.

One may ask why does dollarization occur? Dollarization primarily comes about when there is inflation risk. This concept can be explained from the theory of Purchasing Power Parity. In periods of very high inflation, residents are prompted to seek alternative currencies to perform the functions of money, first as a store of value, unit of account and later as a medium of exchange[1]. The lost in the purchasing power of the local currency coupled with the risk of the stability of its future value leads to the use of an established foreign currency for most of the functions of money, leading to dollarization.

Other reasons could stem from situations where there exist excessive imports relative to export in the domestic country. From basic demand and supply analysis, any activity that triggers excess demand for a commodity increases its price, which in this case is the exchange rate.

One stylized fact in the international finance literature is that whiles dollarization increases in times of hyper-inflation, de-dollarization does not usually occur at least not completely when inflation levels decrease. Rather, domestic residents continue to use the foreign currency. There are two primary reasons for this effect. First of all since the foreign currency becomes widely used within the domestic economy, it persists in its usage even after inflation levels decline.

Also, there arises the problem of a perception of future expected depreciation of the domestic currency. Even when the domestic currency becomes relatively stable for a period, domestic residents, still perceive the foreign currency to be less-risky (stable) and more likely to preserve better value relative to the domestic currency. In this case, dollarization continues to persist due to the lingering doubts in the minds of domestic residents about the future stability of their local (domestic) currency.

THE CASE OF GHANA

Below is a side-by-side time-series graph showing a 6-month GHS/USD exchange rate graph, along with a 6-month inflation rate graph for the same period, spanning the period August, 2013 to February 2014. There was an average exchange rate of 2.27 GHS for $1 over the 6-month period and 20.3% depreciation in the Ghana cedi for the same short period. Within the same period, inflation behaved in a parallel pattern to the exchange rate, with an increase in inflation from 11.8% in August 2013 to 13.8% in February 2014. This positive correlation shows the direct impact of inflation on a country's nominal exchange rate. Thus, the continuous depreciation of the Ghana cedi in recent times has been preceded by a continuous increase in the inflation rate over time.

As mentioned earlier, Ghana's heavy dependence on imports for domestic consumption does not make the situation any better, since this process puts excessive pressure on the price of the cedi (exchange rate) on the world exchange market.

Ghana has been seeing the repercussions of the instability of its currency in myriad forms. For example, there are an increasing number of institutions and agencies who quote prices for their goods and services in USD (eg. The real-estate market, hotels, etc). An interesting twist to this story is that, though remittances in USD into Ghana in these times will be worth more in cedis, with a higher cost of living (as a result of continuous increasing levels of inflation), more money might not directly translate into a better standard of living.

It is important to note that the situation of Ghana is one of partial dollarization rather than full dollarization. In a partially dollarized economy, policymakers face several challenges to the conduct of monetary and exchange rate policies.

In a reaction to this problem, earlier this month, the Bank of Ghana introduced some measures in the form of directives to help curb the spate of the dollarization problem. Many authorities view the displacement of domestic currency as a loss of sovereignty. Though that is a typical reaction to think of in the time of crisis, I believe, a more stable approach would be for the government to intervene in the forex market by using its foreign reserves to prop up the cedi which is typically seen in a managed floating exchange rate systems. This will ultimately make the cedi stronger and reduce some of the effects of the dollarization.

In addition, the central bank’s credibility to maintain the pegged/managed exchange rate will depend on having sufficient foreign reserves to support the peg. I believe the question is whether the central bank has enough reserves to control such a process?

In conclusion, a better way to approach the problem of dollarization is for the Central Bank to build confidence in the monetary system. Also, given that inflation is the main driver of the depreciation of the cedi, measures should be put in place to stem inflation to appreciable levels sustainable for economic growth. Finally, Ghana has to make efforts to wean itself from being import dependent into becoming export led.

[1] Under official dollarization, the foreign currency is used basically for all the functions of money including medium of exchange and unit of account.